There's no one-size-fits-all approach to transition economies. But slow and steady often wins the race.

By Justin Yifu LinJustin Yifu Lin is senior vice president and chief economist of the
World Bank.

September 21, 2012 - 3:26 pm

The following is excerpted from The Quest for Prosperity: How Developing Countries Can Take Off by Justin Yifu Lin. Lin, was until quite recently, the chief economist of the World Bank (2008-2012) — and probably the first western-trained economist to serve a leadership role in the People’s Republic of China. Oh, did I neglect to mention his dramatic past?

Lin was born in Taiwan and while serving in the Republic of China’s army as a captain in 1979, defected to mainland China just as Deng Xiaoping was opening the country to capitalism. Received warmly, he rose quickly in academic ranks. He later studied in the United States (University of Chicago, Yale) where he was rejoined by his wife and children whom he’d left behind in Taiwan. Lin is the founding director of the China Centre for Economic Research and Beijing University.

The new book is especially interesting because it outlines a hybrid “structuralist” approach to the transition from planning to free markets. Perhaps not surprisingly, Lin contrasts the structuralism with both the “shock therapy” approach (that largely worked in Poland, but failed miserably in Yeltin’s Russia) and the neo-liberal Washington Consensus (stabilize prices, get market incentives right, privatize) that has a mixed record in developing countries.

You can read Lin’s book as a fine economist’s analysis of the growing pains of developing countries. Or you can read it as the product of China’s own pragmatic turn to capitalism. Actually, I’d suggest both. — Peter Passell

Big Bang or Gradualism?

A crucial issue in economic transition has been the choice of strategies for sequencing reforms. Two broad options — each with some nuances — have been implemented by Eastern European and Asian countries in the move from plan to market: the Big Bang, or “shock therapy,” and the gradualist approach.

Proponents of the Big Bang wanted to eliminate government distortions in socialist and developing countries, setting up well-functioning market systems in their place as soon as possible. They expected that market competition and quick privatization of state-owned enterprises would increase efficiency.

Post-communist leaders in Poland were among the most vocal proponents of that approach. When Jeffrey Sachs (then an economics professor at Harvard) was invited to advise the reformist movement Solidarity in 1989, he was told: Give us the outline that you see fit, but make it a program of rapid and comprehensive change. And please, start the outline with the words: "With this program, Poland will jump to the market economy."

Perhaps because former Polish trade union leader Lech Walesa was an electrician before he entered politics, he had a lightning approach to policies that seems to have served him rather well. Only four years after creating Solidarity (the Soviet Bloc’s first independent trade union) in the suburbs of Gdansk in 1980, he challenged the military regime of General Wojciech Jaruzelski and was awarded the Nobel Peace Prize. His charisma and strong support from the Western world helped him topple the Polish government, and he became president in 1990. He brought with him a team of radical reformists, such as the brilliant economist Leszek Balcerowicz, who served as deputy premier and minister of finance in the first Solidarity-led government after the fall of communism.

Following the wisdom of 17th century Japanese martial arts master Miyamoto Musashi, who said, “You win battles by knowing the enemy’s timing and using a timing which the enemy does not expect,” Balcerowicz argued persuasively that the short period of euphoria and “extraordinary politics” after the demise of communist regimes presented a unique opportunity in which reformers had to move rapidly to put in place new democratic and market-oriented institutions and to dismantle the massive structural distortions and disincentives of the socialist economy. He therefore made a strong case for the Big Bang on both political and economic grounds.

Politically, he asserted that economic reforms were easier to adopt and implement through a comprehensive program than through a lengthy process of piecemeal and often painful measures, which would leave more time for old-liners and conservative forces with the opportunity to oppose it. Economically, Balcerowicz said, radical reform was more likely to control inflation, signal a new era, build confidence and generate new structures from which there could be no turning back. “Delay will only worsen the macroeconomic situation,” he said, while “a gradual or mild stabilization program will most likely fail to overcome inflationary inertia and expectations.”

That same Big Bang thesis was advanced by many others, including Swedish economist Anders Aslund, who differentiated between “the developed socialist countries of Eastern Europe and the former Soviet Union” and “developing socialist countries like China and Vietnam.” Aslund first observed that Western-style democratization appeared to have been a precondition for a successful transition to a market economy. He then went on to suggest, “There are compelling reasons not only for the rapid destruction of the old order, but also for the speedy construction of a new democratic state.”

The slower the destruction of the old system, he argued, the more trouble and pain the transition would bring: “Given time, communist-holdover officials will find ways to transform their remaining power into property (whether by outright thievery or more subtle methods,) thus exacerbating inequalities, undermining public confidence in the state, and preparing the ground for potentially undemocratic populism.”

Such a prescription did not take into account the underlying viability problem in the economic system. Decades of central planning and forced industrialization created a massive structure of non-viable firms in the prioritized heavy industries. For the rapid transition to work, the economy would need to effortlessly reallocate resources from those industries to a market-oriented structure. However, equipment and workers in the prioritized heavy-industry sector could not be relocated immediately (or at all) to light industries and the service sector. The result would have been a collapse of the priority sectors, mass unemployment, and social and political instability.

A more nuanced approach to reform, quite different in practice from the typical Washington Consensus prescription but inspired by it, was advocated by a group of leading macroeconomists who argued that the economic transition from communism should proceed in sequence: stabilization, price liberalization and privatization had to be implemented rapidly, whereas restructuring should take time (a decade or more).

Almost all Eastern European countries entered the post-communist era with substantial fiscal deficits and excessive money creation. Drawing heavily on the Latin American experience with stabilization programs, the macroeconomists suggested that budget deficits and money creation had to be brought under control at the outset of transition and that prices had to be liberalized, because price controls would only perpetuate the shortages recorded under socialism. They also suggested that inflationary shocks be contained, where necessary by monetary reform involving partial confiscation of nominal assets.

Unfortunately, neither the Big Bang nor the more nuanced version of the Washington Consensus worked smoothly for post-communist countries. The prevailing wisdom embodied in their prescriptions often failed, and some countries could not come up with viable strategies for managing their structural transformation and guiding their industrial and technological upgrading. In Russia, for instance, most prices were liberalized in January 1992, but macroeconomic stabilization was not implemented because there was not enough political support among key policymakers for the unemployment that would have resulted.

In April 1992, the People’s Congress instructed the Russian government that the country’s priority was to “stabilize production,” meaning propping up employment in state firms through credit (and thus money) creation. As a result, inflation never fell below nine percent a month in 1992.

But in June the Supreme Soviet approved a plan for fast privatization. State capital was quickly sold at bargain prices to a small group of people, subsequently known as oligarchs, who had financial assets or political connections and could reap extraordinary gains. That, in turn, created new political-economy problems, which Russia is still struggling to address nearly two decades later.

Olivier Blanchard (an economist at MIT), who had recommended the nuanced version of the Big Bang, acknowledged that ambitious and clever plans have been disfigured by political compromises, bogged down in political fights, tied down by bureaucratic bottlenecks and foot dragging, sabotaged by those who would lose most from their implementation. The basic lesson is clear: privatization is not about the distribution of assets belonging to “the state,” which can dispose of them as it wishes, but about the distribution of assets with many de facto claimants: workers, managers, local authorities, central ministries, and so on. Unless these claimants are appeased, bribed, or disenfranchised, privatization cannot proceed.

The new structural economics that I introduce in this book provides an alternative explanation for the failure of both the Big Bang and its nuanced version.

Socialist economies that had adopted strategies inconsistent with their comparative advantage had a large number of non-viable enterprises in the government’s priority sector. Without government protection and subsidies, most of these enterprises were unable to survive in a competitive market. In some small post-communist countries such as Estonia, Latvia, and Lithuania that had only a limited number of such enterprises, the output and employment of those enterprises were limited and Big Bang reforms could realistically eliminate all government interventions at once.

With the abolition of government protection, these non-viable enterprises became bankrupt, but given their small relative contribution to the economy, the “transition costs” were small. The originally suppressed labor-intensive sector thrived, especially with inflows of foreign direct investment, and newly created employment opportunities in these industries could absorb labor and compensate for the losses from the bankruptcy of non-viable firms. As a result, the economy could grow soon after implementing the shock therapy, with a smaller initial loss of output and employment.

In larger countries, where the number of non-viable firms was large, forceful application of the shock therapy resulted in large-scale bankruptcies and mass unemployment. To avoid such dire consequences and sustain the non-viable enterprises in the advanced industries for political or military purposes, the governments had no choice but to attempt the nuanced approach offered by the leading macroeconomists: immediate stabilization, price liberalization and privatization, but postponement of the restructuring.

But this approach was logically inconsistent and self-defeating. Stability could not be achieved if prices were liberalized and non-viable enterprises were privatized while the restructuring was postponed. First, most enterprises in the government’s priority sector had monopoly power and would have raised their prices once controls were lifted. Second, the private entrepreneurs had more incentive than the state-owned enterprise managers to use the viability issue as an excuse to lobby for more subsidies from the government because they could directly benefit.

However, government revenues declined in the aftermath of the transition. Rather than the stabilization its proponents intended, this approach could lead to hyperinflation in the transition. Indeed, that was exactly what happened in many Eastern European and former Soviet Union countries. The result was (in the words of NYU economist William Easterly) “shock without therapy.” Easterly has also documented the failure in Eastern European transition economies and provided evidence that it was part of a broader stagnation of developing countries that adhered to the Washington Consensus.

A different and much more effective strategy for economic transition recommended by the new structural economics is a gradual, pragmatic, dual-track approach that recognizes the endogeneity (self-perpetuating nature) of the distortions and the viability issue of enterprises in the priority sectors. It recommends that the government provide some transitory protections to non-viable firms in the priority sector to maintain their stability in the transition, but to liberalize private firms and FDI and facilitate their entrance into sectors in which the country has comparative advantages so as to improve resource allocation, tap the advantage of backwardness and achieve dynamic growth.

The capital accumulation resulting from rapid growth in the new sectors will make many firms in the old prioritized industries viable. Dynamic growth will also create the necessary conditions, including financial resources and job opportunities, for removing the distortions in a manner reminiscent of Kaldor’s (Nicholas Kaldor, the great Cambridge economist) characteristics of 20th century growth, which implies that the policy change will increase the total social welfare and that the losers will be compensated for their losses so no one in the economy loses from the policy change. In this way the policy resistance to the reform can be minimized.

The process is one of opening markets, while also providing government support to facilitate the growth of new industries. For example, special economic zones are fully compatible with this gradualist approach: reforms and supportive infrastructure are established initially in limited geographic areas and support specific sectors during the economic transition. Elements of this approach have been implemented successfully in transition economies around the world.

Reprinted with permission from Princeton University Press. All rights reserved.